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Page 1
The Morning Session of the 2011 Level III CFA Examination has 9 questions.
For grading purposes, the maximum point value for each question is equal to the
number of minutes allocated to that question.
Question
1
2
3
4
5
6
7
8
9
Topic
Minutes
15
23
26
23
20
19
22
16
16
Total:
180
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Questions 1 and 2 relate to the Becker family. A total of 38 minutes is allocated to these
questions. Candidates should answer these questions in the order presented.
QUESTION 1 HAS TWO PARTS (A, B) FOR A TOTAL OF 15 MINUTES.
Robert Becker, age 75, retired 5 years ago from the building products business that he founded.
After his business, Buildco, went public in the 1990s, he remained as CEO and continued to
hold shares in the company. After his wifes death, Becker hires Emily Frost, a portfolio
manager and trust specialist, to help with his estate planning. Becker establishes a revocable
trust and an irrevocable trust.
Income, realized capital gains, and estate assets (at death) are all taxed at a flat 20% rate. For the
revocable trust, the cost basis of investments increases to the market value on the date of
Beckers death, and the assets are subject to estate taxes. For the irrevocable trust, the cost basis
of investments does not change, and the assets are not subject to estate taxes.
Currently, the two trusts each have 2.0 million U.S. dollars (USD) of their assets in Buildco
shares, with a cost basis of USD 200,000 each. All Buildco shares have unrealized capital gains.
Becker has the following two immediate objectives as part of his estate planning:
A.
Objective 1:
Sell USD 1.0 million of Buildco shares while minimizing total taxes.
Objective 2:
Put additional assets into a trust to protect those assets from potential
future legal claims against Becker.
Determine which trust (irrevocable, revocable, or both equally) is more appropriate for
each objective:
i.
ii.
Objective 1
Objective 2
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Frost meets with Becker to compare their views on investing. Four discussions from that
meeting are shown in Exhibit 1.
Exhibit 1
Selected Discussions from Becker Frost Meeting
Discussion
Speaker Discussion
Number
Becker: The first thing you might notice about my investment style is that I favor
growth investments over income-producing assets.
1
Frost: I dont think that is the right approach. Equities might deliver higher
long-term returns. However, for a trust portfolio, I prefer that the client
knows the size and timing of the cash flows he will be receiving. Thats
what an investor gets with bonds.
Frost: I notice you hold a significant position in Rolling Mix Cement shares.
Becker: Rolling Mix Cements CEO used to run the western operations for
Buildco. He did a wonderful job for us, so I think Rolling Mix shares
are great to own.
Frost: I was looking at the mutual funds in your portfolio and can see that you
purchased an equal amount across four mutual funds.
Becker: I think that mutual fund family offers four great products. So I bought
all of them: an EAFE large-cap fund, a U.S. growth fund, a U.S. smallcap fund, and a U.S. corporate bond fund.
Frost: I notice you have many portfolio positions where the current values
have been below cost for awhile.
Becker: Investing requires patience. You have to give things time to work out.
B.
Identify the discussion in which one of the participants best illustrates each of the
following behavioral biases:
i.
ii.
iii.
representativeness
frame dependence
aversion to ambiguity
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irrevocable
1. Sell USD 1.0
million of Buildco
shares while
minimizing total
taxes.
revocable
both
equally
2. Put additional
assets into a trust to
protect those assets
from potential
future legal claims
against Becker.
irrevocable
revocable
both
equally
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1
ii. frame
dependence
2
3
4
1
iii. aversion to
ambiguity
2
3
4
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Page 9
Questions 1 and 2 relate to the Becker family. A total of 38 minutes is allocated to these
questions. Candidates should answer these questions in the order presented.
QUESTION 2 HAS FOUR PARTS (A, B, C, D) FOR A TOTAL OF 23 MINUTES.
Five years have passed. Robert Becker recently died and left his estate to his only child,
Michael. Michael and his wife are both 50 years old and have no children. Michael expects to
receive his after-tax inheritance of 8.0 million U.S. dollars (USD) at the end of this year. The
Beckers both plan to retire at that time, and are meeting with Emily Frost to help them establish
an investment plan.
The Beckers currently do not have an investment portfolio and they own a home valued at
USD 3.7 million. At the end of this year, the Beckers outstanding debt will be USD 3.5 million
(home mortgage) and USD 150,000 (consumer debts). The Beckers will pay off their mortgage
and their consumer debts soon after the inheritance is received.
The Beckers currently have a combined after-tax salary of USD 475,000, current-year living
expenses of USD 250,000, plus annual mortgage payments (principal + interest) of
USD 225,000. Michaels company pension will pay him USD 48,000 after-tax next year, and
then payments will grow at the rate of inflation, which is expected to be 3% annually. His
employer will continue to pay all of the Beckers medical costs until death. Both the pension and
health benefits will continue to accrue to Beckers wife, if he dies first. The Beckers expect their
living expenses will also continue to grow at the rate of inflation until one of them dies. At that
time, they expect the survivors living expenses will decrease to 75% of their combined
expenses, and then continue to grow at the rate of inflation.
The Beckers intend to fund their living expenses with Michaels pension and investment income
generated from their investable assets, which do not include their home. The Beckers consider
their investment base to be large, and want their portfolio to be invested conservatively. They
want to maintain the real value of their investable assets over time, and plan to leave their estate
to charity. All income and realized capital gains are taxed at 20%.
A.
Calculate the after-tax nominal rate of return required for the Beckers first year of
retirement. Show your calculations.
(8 minutes)
B.
Discuss two factors specific to the Beckers situation that decrease their risk tolerance.
(4 minutes)
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C.
Level III
Formulate each of the following constraints for the Beckers investment policy
statement (IPS):
i.
ii.
liquidity
time horizon
(4 minutes)
Several years later, the Beckers again meet with Frost. Their investable portfolio is now valued
at USD 7.0 million. The Beckers state that their primary goal is to maintain their current living
standard as long as they live. The Beckers also want to leave a charitable gift of at least
USD 5.0 million from their investable assets after they have both died. However, they are not
willing to risk running out of money in their old age to achieve this secondary goal. The Beckers
agree with Frost to assume a 25-year time horizon.
Frost produces Monte Carlo simulations for the Beckers using two portfolios with different asset
allocations. The simulations use a long series of historical index data for each asset class in the
two portfolios. The resulting distributions of terminal values are shown in Exhibit 1. All
terminal values are after expected taxes and spending needs have been met.
Exhibit 1
Monte Carlo Simulation Results
Projected Portfolio Terminal Values at 25 Years
Terminal Values
(USD thousands)
Percentile
Portfolio A
Portfolio B
D.
95th
17,808
35,814
90
th
11,916
21,729
75
th
9,192
14,454
50
th
4,896
8,813
25
th
2,154
5,016
10th
294
5th
39
i.
ii.
Discuss two improvements Frost could make in her Monte Carlo simulations.
(7 minutes)
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Level III
A.
The WU endowments primary goal is to maintain the real value of its assets
over the long term.
Tuition and grants fund the remainder of the annual operating expenses.
The WU endowment:
uses a simple spending rule with a 5% annual spending rate based on the
endowments beginning-of-year market value.
receives private donations and uses these donations, in part, for its
liquidity needs.
i.
ii.
Calculate the required return for the WU endowment. Show your calculations.
(4 minutes)
B.
Determine how a change in each of the following factors, holding all else constant,
affects the risk tolerance (increases, decreases, does not change) for the WU endowment:
i.
ii.
private donations
expected inflation
Level III
C.
Page 17
Formulate each of the following constraints for the WU endowments investment policy
statement (IPS):
i.
ii.
liquidity
time horizon
(4 minutes)
A year has passed since Bergens initial review. Due to significant losses in the market value of
the portfolio, the WU endowment now provides less than 25% of WUs operating expenses. In
addition, donations have declined. The investment committee asks Bergen to propose measures
to maintain the long-term real value of the endowment, and reduce the volatility of the
endowments funding of WUs operating expenses. In response, Bergen suggests the following
strategic actions:
Strategic action 1:
Strategic action 2:
Strategic action 3:
D.
ii.
most likely to reduce the volatility of the endowments funding of WUs operating
expenses.
The SU endowments primary goal is to maintain the real value of its assets
over the long term.
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Level III
E.
The SU endowment:
funds SUs operating budget shortfall, but caps its contribution at its
spending maximum.
Discuss three factors that suggest the SU endowment has greater risk tolerance than the
WU endowment.
(6 minutes)
Page 20
Level III
increases
i. private
donations
decreases
increases
ii. expected
inflation
decreases
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Level III
1
i. least likely to
assist the
endowment in
achieving its
primary goal.
1
ii. most likely to
reduce the
volatility of the
endowments
funding of WUs
operating
expenses.
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Page 25
2.8%
3.6%
2.2%
2.0%
0.4
Calculate the projected average annual real GDP growth rate using the Cobb-Douglas
production function and the information in Exhibit 1. Show your calculations.
(4 minutes)
Shipp tells Wallbank that the Cobb-Douglas projection of GDP growth may be affected by two
actions the countrys government is considering:
B.
Action 1:
Action 2:
Decrease the minimum retirement age by three years for all workers.
Determine the initial effect (increase, decrease, or no change) each action would most
likely have on the countrys GDP growth trend. Justify each response with one reason.
Note: No calculations are required. Consider each action independently.
Answer Question 4-B in the Template provided on page 28.
(6 minutes)
Shipp compiles the data to estimate the intrinsic value of the countrys broad equity index. The
current annual dividend for the index is 10.00 U.S. dollars (USD). She assumes the initial
dividend growth rate is 6.0% and that over 15 years the dividend growth rate will decline linearly
by a total of 50%. The assumed discount rate to perpetuity is 5.5%.
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C.
Level III
Calculate the countrys broad equity index price level implied by the H-Model. Show
your calculations.
(4 minutes)
Shipp tells Wallbank there are two alternative models that can be used to determine the fair value
of an equity market. These models are the Fed Model and the Yardeni Model. She compiles the
data in Exhibit 2 to use with these two models.
Exhibit 2
Capital Market Data
10-year government bond yield
10-year A-rated corporate bond yield
Forward broad equity index earnings yield
Consensus long-term earnings growth forecast
Weighting factor, d
4.05%
4.70%
3.95%
7.50%
0.10
After listening to Shipp explain the differences between the two models, Wallbank questions the
use of the Fed Model, since it excludes important factors that the Yardeni Model includes.
D.
Identify one factor that is excluded from the Fed Model, but is included in the Yardeni
Model. Discuss whether the Yardeni Model accurately addresses that factor.
(3 minutes)
E.
Determine, using the data in Exhibit 2, if the broad equity market is overvalued, fairly
valued, or undervalued according to the:
i.
ii.
Fed Model
Yardeni Model
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Level III
increase
1. Issue new
regulations to
reduce
environmental
pollution by
manufacturers.
decrease
no change
increase
2. Decrease the
minimum
retirement age by
three years for all
workers.
decrease
no change
Level III
Page 31
overvalued
i. Fed Model
fairly valued
undervalued
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Level III
overvalued
ii. Yardeni
Model
fairly valued
undervalued
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Level III
Page 35
Welch explains to Finnegan that she is currently following an asset-only (AO) approach to
strategic asset allocation. He strongly advises her to adopt an asset/liability management (ALM)
approach.
B.
Discuss three reasons, based on Finnegans circumstances, why an ALM approach would
be more appropriate than an AO approach.
(6 minutes)
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Level III
Welch also suggests that Finnegan consider her human capital in the asset allocation process. He
believes that Finnegan should reduce her allocation to equities at this time.
C.
Discuss two reasons, based on her human capital, why Finnegans current allocation to
equities should be lower.
(4 minutes)
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Page 41
Wangs benchmark index contains three sectors of investment-grade corporate bonds. Relative
to his benchmark index, Wang may alter his sector weights, credit quality, and duration. He is
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Level III
restricted to investing in investment-grade bonds, and only in the three sectors included in the
benchmark index. Exhibit 2 provides details of his portfolio versus the benchmark index.
Exhibit 2
Regional European Actively Managed Corporate Bonds
Portfolio and Benchmark Index Summary
Portfolio Characteristics
Wangs Portfolio Benchmark Index
Sector weights: consumer cyclicals
46.0%
33.3%
consumer non-cyclicals
21.0%
33.3%
utilities
33.0%
33.3%
Average credit quality*
A
A
Duration**
4.8
4.8
* Bonds in both the portfolio and the benchmark index range in credit quality from
BBB (lowest investment grade) to AAA (highest investment grade).
** Short-, mid-, and long-term bonds are each 1/3 of both the portfolio and the benchmark index.
B.
Given the economists forecast, Wang is now considering the following trading strategies within
his portfolio:
Trading strategy 1:
Trading strategy 2:
Trading strategy 3:
C.
Describe the trades that Wang could use (buy/sell bonds as appropriate) to implement
each trading strategy. Justify each trade, based on the economists forecast.
Note: Consider each strategy independently.
Answer Question 6-C in the Template provided on page 45.
(9 minutes)
Level III
Page 45
1. sector
rotation
trades
Bonds to sell:
Bonds to buy:
2. credit
adjustment
trades
Bonds to sell:
Bonds to buy:
3. yield
curve
adjustment
trades
Bonds to sell:
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Page 47
B.
Discuss two reasons why Orcas board of directors most likely does not represent the best
interests of shareholders.
(4 minutes)
C.
Discuss two benefits that may be realized by Orca replacing some of its debt with equity.
(4 minutes)
D.
Discuss two reasons why Horizon is not likely to be an effective active monitor of Orca.
(4 minutes)
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Level III
Nationwide is also considering purchasing shares of Acorn Co., a timber harvesting firm in an
emerging market. Nationwide believes that Acorns external corporate governance framework
provides poor legal protection of shareholder rights. Nationwide knows that Acorn has been
considering the issuance of a cross-listed security such as an American Depository Receipt
(ADR). Nationwide believes that a cross listing could improve Acorns corporate governance.
E.
Explain two reasons why the issuance of ADRs could have a positive effect on Acorns
corporate governance.
(4 minutes)
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Level III
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Determine whether the use of the following VaR models is appropriate for the WB
Polish equity portfolio:
i.
ii.
Historical VaR
Analytical VaR
1,400
6%
7%
Calculate the 1% monthly VaR in PLN for the portfolio in Exhibit 1. Show your
calculations.
(5 minutes)
Lipkas manager asks her to evaluate the risks of a potential new portfolio denominated in
Lithuanian litas (LHS) shown in Exhibit 2. Lipka performs a stress test on the portfolio over a
three-month horizon and estimates a total return in PLN using the following assumptions:
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Level III
C.
Calculate the profit or loss in PLN for the Lithuanian portfolio in Exhibit 2, under the
assumptions in Lipkas stress test. Show your calculations.
(5 minutes)
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i.
ii.
Exhibit 1 presents the performance results for one of the Funds asset managers, Vermillion
Asset Management. This manager invests in a small number of sectors within a broad equity
universe. Vermillions investment objective is to outperform a custom benchmark determined
by Gladwynes investment committee.
Exhibit 1
Vermillion Asset Management
Gladwyne Manufacturing Pension Fund Specialized Equity Portfolio
Performance Results
1 January 31 March 2011
Weight (%)
Return (%)
Industry Sector
Custom
Custom
Portfolio
Portfolio
Benchmark
Benchmark
Consumer durables
26.30
21.90
4.55
4.90
Consumer nondurables
31.00
34.80
3.60
3.10
Financial
21.20
20.90
3.90
3.30
Technology
21.50
22.40
1.30
0.20
Total portfolio
100.00
100.00
3.42
2.80
B.
i.
Calculate the pure sector allocation return for the consumer durables sector of the
portfolio for the quarter. Show your calculations.
ii.
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Level III
As part of the annual review of the Fund, the investment committee is considering two new fixed
income managers. Exhibit 2 presents historic data provided by the managers for portfolios
managed to the same benchmark.
Exhibit 2
Potential Fixed Income Managers for
Gladwyne Manufacturing Pension Fund
Performance Attribution Analysis for the Year Ended 31 December 2010
Manager A Manager B
Effect
(%)
(%)
Interest rate effect:
Expected
4.26
4.26
Unexpected
0.72
0.72
Subtotal
3.54
3.54
Interest rate management effect
0.08
0.12
Other management effects
0.11
0.32
Trading activity return
0.14
0.13
Total return
3.71
4.11
To gain insight into their active management practices, Cobalt reviews their performance results.
She notes the following statements made by the managers in their proposals:
C.
Manager A:
Manager B:
Conclude (yes, no, cannot determine with the information provided) whether each
statement made by the managers is consistent with the data in Exhibit 2. Justify each
response with one reason.
Answer Question 9-C in the Template provided on page 65.
(6 minutes)
Level III
Page 65
Manager A:
Our strategy
is to add value
by actively
managing the
duration of the
fixed income
securities in the
portfolio.
Manager B:
Our strategy
is to add value
by identifying
undervalued
securities and
sectors to take
advantage of
bonds that are
mispriced by
the market.
yes
no
yes
no